By Marshall Auerback, a portfolio strategist who writes for New Deal 2.0

Something is very wrong with Japan.

The Japanese economy has been much weaker than any other major economy for a while now: over the last business expansion, through the Great Recession, and in the recovery since the Great Recession trough. Japan’s business cycle has been led by its exports for well over a decade. It has been my guess that overinvestment in industrial tradeables by Japan’s Asian mercantilist competitors, especially China, along with yen strength has been seriously undermining the Japanese economy for some time. The recent all-time new highs in Chinese overinvestment and this year’s crazy yen strength would only accelerate this process and might well presage what lies ahead for the rest of the world, especially the US.

Throughout the past month, the data coming out of Japan has uniformly poor. This data — especially a METI forecast for a coming 3% decline in industrial production in the next two months — has been of a particularly gloomy and alarmist nature, especially from an organization such as METI, which has tended to be overly optimistic in its forecasts. But the data now says Japan may already be rolling over into a recession despite a growing global economy and a booming neighboring China. The markets right now with their yen “bid” seem as “out to lunch” regarding Japan as they were out to lunch regarding Europe last May/June, when the ECB contained an incipient currency/solvency crisis by backstopping the nations’ respective bond markets.

What to do about Japan? Both Federal Reserve Chairman Ben Bernanke and economist Paul Krugman recommended to the Bank of Japan over a decade ago that it adopt a significantly positive inflation target and conduct monetary policy with that objective. Bernanke suggested that the Bank of Japan do this by buying foreign exchange and issuing monetary base until that target was reached. Similarly, in the recent Democratic Party of Japan (DPJ) leadership election campaign, challenger Ichiro Ozawa argued for such an inflation target for the Bank of Japan.

Although Naoto Kan retained his leadership position (and, hence, remains the country’s Prime Minister), there are indications that he has begun to embrace much of the Ozawa platform. About a week ago, the Kan government moved to purchase significant quantities of foreign exchange through unsterilized issuance of yen in order to depreciate the yen. But it has not followed through after an initially promising start.

Unless the Bank of Japan follows Ozawa’s recommendation and conducts foreign exchange intervention on a scale consistent with ending deflation and reestablishing inflation, it will probably fall short of the policy actions needed to weaken the yen. This cannot be done through quantitative easing per se. I have argued before that QE in terms of targeting reserve balances is ineffective. It is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves. The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves, then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending. Right?

Wrong. Bank lending is not “reserve constrained”. Banks lend to any credit-worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves, then they borrow from each other in the interbank market. Or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).

The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves. But whereas a policy to target reserves might be in effective, this does not appear to be the objective right now in terms of what the Federal Reserve is currently doing in the US. In effect, it is trashing bonds as well as cash (getting bond yields lower through the promise of additional, but as yet undisclosed, measures) and inciting investors into risk assets, notably equities, on the premise that this will increase spending. In effect the Fed is targeting equity prices as a means of buttressing consumption.

Will it work? With the private non financial debt to GDP ratio still at 170% and only ten percentage points off its highs it appears that there are very high risks in the Fed’s approach. The markets may well call “Helicopter Ben’s” bluff and a failure to see some positive economic outcome from the embrace of outright QE could well cause a serious crisis of confidence in the US markets.

But let us take Japan; clearly, a very different situation pertains. For one thing, Japan can buy foreign exchange and sell yen forever and get the exchange rate down. The BOJ has done so in the past and these interventions have for the most part been successful. The exchange rate matters far more for Japan, whose ratios of exports to GDP and industry to GDP are far higher than in the US. Furthermore, if Japan manages to reverse deflationary expectations, there may be a real financial and real response. Japan has reduced its ratio of private non financial debt to GDP by FIFTY percentage points, not ten. There is more scope for loan demand. More important, in addition to less private debt, the liquid assets held by the private sector in Japan is just huge. The ratio of M3 to GDP has gone from 105% to 164% in twenty years. The public holds huge quantities of government bonds and, if the Japanese public thought they might not earn anymore the real return generated by deflation, the BOJ could well “chase” the public into a different category of risk assets, such as equities.

Japan has been experiencing a post-bubble adjustment for twenty years. The adjustment process in the US, by contrast, has been going on for a mere two years. It makes a difference. An aggressive intervention by way of forex purchases might really work for Japan.

But what is the alternative? We have just experienced a hint of that: the country’s largest consumer finance company, Takefuji, has just filed for bankruptcy. Deflationary pressures are intensifying again. There has generally been a high correlation between Japan’s ratio of fixed investment to GDP and its ratio of exports to GDP. Both went up in the 2000s into 2008 when the economy began to grow again. However, by 2008 the export growth was slowing. Economist Andrew Smithers blamed it on economic growth in Japan’s trading partners, which he argues was slowing.

Perhaps, but a more plausible thesis is that by that time China was starting to seriously compete with Japan’s export machine. Consider what happened to the Japanese economy in 2008: exports fell by almost forty percent, and of course fixed investment fell in turn. Even more striking is that Japan’s exports have recovered less than any other major economy post the Lehman induced catastrophe — likewise with its GDP. In spite of 20 years of largely subpar growth (with the notable exception of 2003-2007), the Japanese economy’s resilience in the face of ongoing external economic shocks has proven to be quite feeble, particularly in relation to its Asian competitors, especially China. It appears that a combination of Chinese technological advances and overinvestment, along with a super strong yen/dollar exchange rate has created the beginnings of a hollowing-out effect in Japan.

More economic data has come out in the latest Japanese tankan to confirm this abysmal picture. August industrial production fell -.3%. The consensus was looking for a rise of 1.1%. Industrial production is now below the level of January.

Worse yet is the METI forecast for industrial production in September and October. Companies who responded to the Meti survey expect a-0.1% decline in September and a -2.9% decline in October. These METI forecasts are often very wrong. So such a future decline is not set in stone. But my experience is when Japan’s industrial production is moving towards weakness these forecasts are too optimistic. Throughout this year, as industrial production has flattened and began to fall, the METI forecasts, which were consistently predicting significant rises in future months, have proven to be too optimistic. Other data appears to confirm the prevailing gloomy picture. Earlier last September, Japan recorded a large monthly fall in export volumes. Over the previous two months of July and August, the average level of exports at 3.8% is below the average of May and June. The Japan manufacturing PMI is also falling and is now below 50.

Tomorrow, I’ll examine the specific impact of China’s policies: how it has adversely impacted Japan and what it might portend for the US in the future.

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28 comments

Wrong. Bank lending is not “reserve constrained”. Banks lend to any credit-worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves, then they borrow from each other in the interbank market. Or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost). Marshall Auerback

Thanks for repeating this important point. Would it be fair to say that banks don’t need savers at all?

1) they are legal.
2) they lend out their product rather than spend it.
3) their liabilities to other banks can wreck them.
4) without the Fed (lender of last resort) they would be drastically limited in the amount of leverage they could use.

yeah, but I think it works a bit differently on the amount of liability: essentially just create and when debt goes bad, it is just an accounting problem. Write it off or beg for bailouts. Monetary levels have been set by the private market place for ages through CDO (CDO bypass reserve ratios).

Marshall’s observations as we enter the second generation of economic woes in Japan is spot on, though not quite so sure about the China connection.
I look forward to part-deux.

In the meantime, we should be hopeful for Japan as one of her obviously progressive economists capable of thinking outside the post-Keynesian box, Dr. Kaoru Yamaguchi, has come up with a comprehensive dynamic modeling on the potential for ending Japan’s tremendous debt-saturation.

Dr Yamaguchi first presented his study results at the International Conference on System Dynamics in Seoul back in July.
He also presented last week at the American Monetary Institutes Annual Conference in Chicago, along with Steve Keen and Dr. Michael Hudson.

If you check out Steve Keens blog on the conference, he says Dr. Yamaguchi’s Systems Analysis model is superior to anything he has seen, and far superior to his own.
The results of changing to a debt-free money system is the elimination of the national debt of Japan, supporting robust growth without inflation.

Dr. Yamaguchi’s model is available to the public from the Doshisha University site, where he is the Director of the Green MBA program.

Hadn’t read zarlenga or yamaguchi. Diving into it and I find it highly stimulating. I wish Yves et al would run an expose on this framework of debt free money so we could take a whack at it.

Clearly debt bearing money has the problem of endogenous exponential money growth (see Andreesen work, a keen acolyte). This simply says that debt as money creates accumulation of monetary mass at least at the rate of return (minus rate of default). Bottom line you see boom/bust in the basic equations of debt as money.

In reading the actual paper you referenced, I was first very impressed and want to read more but immediately taken aback by a few glaring points.

1/ not to be crass, but anyone who references “the creature of jekyll island” as serious works needs to have his mind examined. I have read that book, it is shallow in its economic treatment, long in its conspiracy theory approach, and frankly batshit crazy when it comes to “abolish everything and go back to gold before the world comes to an end”. It is a nice historical read, that reminds you that the FED was born out of a private effort of the banking cartel and managed to put the word “federal” in its name. So you have the modern generation libertarians, running around claiming it was “the government that created an environment of cheap money” when in fact it was the banks, first through base money then through securitization, more on this in 2.

2/ It does not take into account the shadow banking system and the CDO creation which really was the main monetary creation nowadays. I think it was a japanese central banker that said “we have lost control of the aggregate monetary levels”, because these were really set by the private sector through CDO and the bypassing of reserve ratios. Forget the fact that reserve ratios don’t work either (a favorite point of MMT’ers) in the sense that banks shoot first and ask questions later (lend first, reserve later) and that the FED accommodates levels anyway , the CDO has made ashes of that framework all together.

Actual levels may be better found in global pictures of surplus recycling between china and the OECD. IN other words it misses the main creation mechanism and inflow of money on the market in modern global finance.

3/ it seems highly improbable that such a radical framework would get implemented in the land of the free. This is far fetched beyond capitalism and communism, maybe suited for 22st century but would love to hear the ‘pragmatics’ take on this framework. If anything i see this as being more easily implemented in china, than the US.

4/ I, like many others, deeply distrust a government with infinite free money. Corruption and waste will abound, which make me doubt the claims of “environmentally friendly”. I also distrust the FED as a private entity to set base monetary levels, and the banking system’s “invisible hand” has proven it would do nothing but press the coke pedal like the proverbial mouse, until it blows itself up and the economy with it.

Money is too powerful an instrument to be left to politicians or the private sector. HOW DO WE SET MONETARY LEVELS? The notion of full employment is full of holes imho… USofA would not stop until every redneck has a Ford 350 and a mc-mansion. This would clearly be full employment but environmentally friendly? please? I still see human frailty and greed in dealing with money. I will stick my neck out, maybe monetary levels should be set so that the space of exploration does not result in more bad debt than a X percentage level. If you emit 100 and 97 is used to mainline heroin, then clearly you are not creating “value” but only consuming and destroying. Investment needs to repay for itself. A modicum of for-profit motive is still needed. Maybe a VC like statistical approach to generating innovation may be one venue of research. Housing was not innovation.

5/ I really welcome these “off the wall” approaches. Money as debt, the basis of capitalism (along with equity) may well be a doomed construct in the long run. Basically it works while your economy grows ahead of the rate of growth of money mass (interest-default), but when the economy stalls, then that money for nothing is fraud. Think about it: housing collapses, banks created money for nothing, banks foreclose, banks own the estate. So from nothing banks own everything… TADAH!!!! so yeah, in 25th century “steady state” when no more value is created we need another system. In the meantime you will find it hard to unglue one of the pillars of capitalism (money as debt).

IMHO
Some of it is good. gvt, spends money into existence vs FED lending it into existence.
Some of it so-so. The fractional reserve ratio argument. Forget that FR is not how the system actually works. The point is that it is unfair that the banking system takes a tax on money created out of thin air. That I think is morally true, But still sitting on the fence on the 100% reserve ratio. wouldn’t the transition create massive deflation. And no, the question is REALLY not addressed in zarlenga, in spite of some vague arm waving in that direction.

Frankly some of it just stinks. Private spending would be inferior in number to public spending by definition of how the system works (unless I misread it). And that kind of central command is just what markets contradict. It is also a communist nightmare where private spending is completely muted.

I have bought the book (expensive!!!) just because I enjoy reading about the history of money and this *seems* extensive. But I got to admit that I am feeling more and more like a chump listening to the next crazy with the snake oil that solves the crisis. The AMI sections read like a communist manifesto and will be brushed aside as such unless it cleans its act, that much is clear to me.

Why would a nation of savers who, as the population ages, will become a nation of spenders, want their currency debauched? It seems dim-witted to me. There are many things I do not understand about Japan. Who are the debtors in Japan? The government, nearing 200% debt/GDP obviously is a major player. But on seeking alpha, the figure of total debt/GDP for Japan is listed as 460%. Again, we’ve always heard the Japanese are a nation of savers. Who borrowed that other massive chunk of the total debt? Is that primarily corporate debt? (For the USA, this question is easy to answer — Karl Denninger regularly updates total debt with breakdown into categories.)

If they force the value of the yen down, due to the high savings rate of their population, it is likely the public that is going to take a hit to the benefit of export oriented enterprises.

We do appear to be quite obsessed with growth as the obvious demographic situation in Japan is one of a aging population and decline. The situation likely puts the savings of older Japanese against the relative futures of their younger counterparts.

I am personally quite curious in regard to the ownership stakes that Japanese corporations and banks have in the rest of the regions export oriented enterprises. With the value of its currency at a high level one would expect that its foreign direct investment outflows to be high particularly into the Asian region.

In addition how much of this is external production by Japanese transnationals returning to Japan, either in the form of cheap components for assembly or finished products for the consumer market.

These might be the culprits for a lackluster movement to lower currency value. You have a large and likely vocal segment of the population that would take a substantial loss and powerful interest groups with direct access to the government.

I think the impact of demographics on the Japanese economy is underestimated. It is noted as people get older they tend to spend less. Since its clear that domestic demand can’t keep Japans economy going alone, it has to export. Perhaps this does suggest that the future world wide is a slow economy as the world wide population ages, and the demand for stuff slows. It exposes the problem that to make the goods and services demanded by society does not take all the workers that could work. Perhaps one has to look back to the City of Rome during the empire and bring back bread and Circuses (video games today)

‘A more plausible thesis is that … a combination of Chinese technological advances and overinvestment, along with a super strong yen/dollar exchange rate has created the beginnings of a hollowing-out effect in Japan.’

This has been going on for 15 or 20 years now. In the mid-Nineties, I began telling my Japanese suppliers in the metals industry that Chinese competition was eating our lunch, not only on price, but in QUALITY.

Nonsense, replied Tokyo. China is a ‘primitive’ economy, of gritty, poorly-educated people with calluses on their thick peasant hands. They can’t compete with ‘Technopolis Japan.’ We’ve been selling them crippled machinery with looser tolerances, so the hapless newbies can’t match our quality.

All this turned out to be quite wrong. The Chinese fixed the crippled equipment, and even improved on it. Later I invited the guys from Tokyo to visit some of our US customers, who told them point blank that the Chinese were now their preferred suppliers. The equivalent Japanese product was considered secondary quality, not even acceptable at a discounted price.

Another inherent advantage possessed by Chinese suppliers was a stable, managed exchange rate. Over an order cycle which might run from 6 to 18 months, the Chinese could count on repatriating dollars at a predictable rate. By contrast, the exchange rates of ‘Planet Japan’ fluctuate violently and unpredictably. Big orders have to be hedged, which adds cost. At ¥83, most of the products which we could sell in the US are hopelessly uncompetitive.

Hundreds of papers have been written about Japan’s two decades of stagnation, many by Federal Reserve staffers. I have yet to see a convincing explanation of why Japan couldn’t edge itself out of deflation with a fiat currency. The mysterious Orient is inscrutable in more ways than one, I reckon.

Eamonn Fingleton, who wrote In the Jaws of the Dragon claims that the “lost decades” were greatly exaggerated by Japanese authorities and were really a ruse to help dampen protectionist sentiment towards Japan in the US. While there were certainly some troubles, he claims Japanese officials twisted figures to sell the story of a Japan in economic turmoil. He cites among other things statistics on the increases of Japanese electrical usage during the nineties. He says during the supposed Japanese slump in the nineties this energy-conscience country’s electrical consumption (a key statistic used by intelligence agencies for judging economic growth and which is harder to fake) grew by 30% while in the booming nineties the US, where conservation is hardly practised, energy consumption only grew by 24%.

I have no way to judge these claims but they do make sense from a strategic point of view.

Just as the in heady bubble days of japan miracle, the “malaise” story is overbought. More than likely it has been sold for a reason, as the author of Jaws indicates
Auerback seems to have zero understanding of contemporary consumer psychology in Japan, where saving is seen as cool.

Why should Japanese domestic consumption be growing? What else do most Japanese need? More food? Are they malnourished? More junk that can’t fit in their small abodes? Bigger homes that can’t fit in their small island? More technology? The price of that is falling constantly anyway.

I mean this seriously. Isn’t this possibly the reason the only growth their economy sees is in exports? Is it plausible that they (in very general terms) don’t need or want anything more than what they have? Even if they’re not there yet, we must acknowledge that some society somewhere must eventually reach such a point, no? There’s only so much you can eat, only so much time to fill, and there’s no reason that what you prefer to eat and prefer to spend your time doing is more expensive than what it cost yesterday. Especially in this financialized world where the benefits of growth seem to only accrue to those who already have more than they have time to consume anyway. Methinks there is something deeper here than just investigating the role of money and debt in all this.

Auerback’s reasoning looks like that Takefuji filed for bankruptcy because of intensifying deflationary pressures. But clearly it’s not the main reason for Takefuji’s bankruptcy. Consumer finance companies in Japan are in a predicament because they are facing tremendous claims of overpaid interest from tighter borrowing laws. If the law didn’t change, most consumer finance companies would enjoy huge benefits.

Does those images look like a society in the brink of collapse like Argentina in the 90’s or Detroit shanty town? Can anybody even guess how much it costs to keep the road marking straight and shiny like that, nevermind the building material and quality. (This ain’t manhattan cheap quarry stone marble or precast concrete.)

During their explosive time, they made huge investment in energy saving technology to withstand oil shock and shave production cost. It shows. They can do more with less hydrocarbon compared to anybody.

I am not saying they are a society without a financial problem, but they ain’t Greece and they are solvent. Not so with US budget situation.

・More than 30,000 people commit suicide in Japan annually for the last 10 years.
・Middle class is shrinking.
・Income inequality is widening.
・Young people are postponing marriage due to lower living standard.

– Young people postponing marriage? At least they don’t kill them in war zones or guarding the sprawling military bases network all over the world just to get ahead in society.

Do you even realize how utterly bankrupt the nation will be when it reaches baby boomer peak retirement like Japan now? Dollar won’t keep climbing up so retiree can pay stable/cheaper gasoline like In Japan. I can tell you that. At 5% inflation, $4/gal gas and 150% debt-gdp, US will be argentina in 2020. US retirement has not been paid. Baby boomer will not be able to pay for their retirement.

“shrinking middle class and widening income gap? you got to be kidding.”

I’m not kidding, of course. GINI coefficient has a measurement problem. It wholly depends on how you calculate it. Let me show you one example. Japan’s official statistics show that GINI coefficient was around 0.35 in the early 1980’s, but it rose to 0.532 in 2008. It’s widening, isn’t it?

“At least they don’t kill them in war zones or guarding the sprawling military bases network all over the world just to get ahead in society.”

You’re right. But remember the US is GUARDING Japan, whereas Japan has no obligation to defend the US.

“US will be argentina in 2020”

Argentine GDP grew more than 10% from a previous period this year. Which Argentina are you talking about? Or are you saying that the US will grow much faster than now in 2020?

Also, one of the reasons of sluggish demand in Japan is that they are very concerned about the retirement which they fear they wouldn’t be paid.

“Banks lend to any credit-worthy customer they can find and then worry about their reserve positions afterwards.”

So the banks are currently lending to any credit-worthy customer. And the reports are that businesses are holding a lot of cash which they will not spend on growth until demand goes up. So what would be the point of forcing savers into equitys, if it will not help the real economy? (Bubbles or Wall Street and High Frequency Trading.)

The scarey part of this is that Bernanke, the Treasury, and the financial industries will continue to try one ploy after another until the economy begins to show recovery. Then they will claim that the latest ploy caused the recovery.

“I mean this seriously. Isn’t this possibly the reason the only growth their economy sees is in exports? Is it plausible that they (in very general terms) don’t need or want anything more than what they have? Even if they’re not there yet, we must acknowledge that some society somewhere must eventually reach such a point, no? There’s only so much you can eat, only so much time to fill, and there’s no reason that what you prefer to eat and prefer to spend your time doing is more expensive than what it cost yesterday. Especially in this financialized world where the benefits of growth seem to only accrue to those who already have more than they have time to consume anyway. Methinks there is something deeper here than just investigating the role of money and debt in all this.”

I made this point on Marginal Revolution recently. I experienced this personally myself. Because my apartment is small, I have had to stop buying things except to replace broken or worn out things I already own (so there is still a role for planned obsolence)! Now services and experiences are another matter, but there are so many hours in a day.

While I agree that the Japanese depression is something of sham, it could be that demand can’t expand infinitely due to physical limitations, and Japan is the first country to hit that point. I think this is good news if this is the case, but it runs against many implied assumptions about how modern economies work.